Performance, Profitability Management and Hurdle Rate

Bogie Ozdemir

In this chapter, we will examine risk-adjusted performance metrics. We will show that they are akin to return on equity, and how they are related to the risk perspectives of the shareholders and debtholders (and, for insurance companies, also policyholders) of the FI. In our discussion of the operational details of risk-adjusted performance metrics, we will focus on the performance management of the loan portfolios. We argue that using a uniform hurdle rate in the performance assessment is not appropriate, and instead advocate the use of loan-specific hurdle rates. These loan-specific hurdle rates reflect the required rate of returns for the individual loans, and can be calculated based on market credit spreads (when credit spreads are observable) and based on Merton’s (1974) model (when credit spreads are not observable).

We will show their ex ante, real-time and ex post applications in performance management. In real-time applications, we will show how the length of the intended investment horizon is taken into account in measuring risk-adjusted profitability. In ex post performance management, we will discuss the concept of “trader’s beta” in determining the systematic risk